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China: Debt will be rolled onto the government balance sheet

(…) although I don’t think it is a certainty, I am expecting that the most likely economic outcome for China for the rest of this decade is a combination of much slower growth and rapidly rising government debt. Privatizing assets and using the proceeds to shore up household wealth, directly or indirectly, is politically tough to do.

Contrary to some recent research reports cited in the press I do not think we have seen any substantial rebalancing of the economy towards consumption in 2011. This is largely an argument being made by economists who did not see why Chinese consumption repression was all along at the heart of the growth model. These economists are now too quick, I think, to hail evidence of a surge in consumption, but I find the evidence very weak and more importantly I am convinced that there cannot be a sustainable surge in consumption as long as the investment-driven growth model is maintained and as long as debt continues to rise unsustainably.

And as for debt, it is still rising quickly. As regular readers know I have always argued that the rise in Chinese debt, as bad as it is, was not going to lead to a banking collapse or any other sort of financial collapse because of the way local and specific debt problems would be “resolved”. Debt would simply be rolled onto the government balance sheet.

China has instructed its banks to embark on a mammoth roll-over of loans to local governments, delaying the country’s reckoning with debts that have clouded its economic prospects.

China’s stimulus response to the global financial crisis saddled its provinces and cities with Rmb10.7tn ($1.7tn) in debts – about a quarter of the country’s output – and more than half those loans are scheduled to come due over the next three years.

[in the comments]:

@Dr. Richard – Nouriel Roubini had a wonderful video yesterday in which he interviewed Patrick Chovenac of Tsinghua University about the very bad financial situation in China; this video was released, before the postponement in payments was announced. One of the most important issues they raised is that about half of all of China;s GDP is export driven and an additional large portion is driven by capital investment (e.g. in housing and infrastructure). But these sectors are already at a dead standstill in growth. So, even though China’s official figures may show that GDP growth has slowed to about 8%, that figure cannot be true, and it is more likely that the real figure is a much lower 4% or so. Chovenac said that, in his view, CHINA IS ALREADY HAVING A HARD LANDING..

Regarding your question, Roubini and Chovenac explored the possibility that there would need to be some sort of roll over of the type that now has been announced; and they explained that such a “nominal” default would have real consequences for China’s growth. What will happen when the loan principal is not repaid is that the money that would otherwise return to the banks and be available for new investment will no longer be available. The impact would normally be an extraordinary contraction in bank funds available for lending. But the Chinese leadership does not want this to happen, given its need for about 7% GDP growth to prevent social unrest — particularly in the year when they are transitioning to new leadersip.. So China will have to increase the pool of funds by monetary or fiscal easing. Either easing approach would result in inflation, which also has adverse consequences for social unrest.